We read earlier this week that Goldman projects U.S. companies are on pace to break another record for share repurchases in 2019, almost $1 trillion, a 13% increase over 2018. Companies that actually execute on buyback plans were up 26% through mid-July.
As a general rule, we like the idea of companies using excess cash flow to buy their own shares, thereby reducing the outstanding float and creating a tailwind for Earnings Per Share (EPS) by reducing the denominator. When executed intelligently along with a secular organic revenue and earnings growth story, we believe this financial tool can generate powerful price momentum. Further, at some level, it might suggest that management and the company’s board believe that the company’s shares are being mispriced in the market and they are a bargain. Of course, this isn’t always the case – many companies purchase shares when they are trading at or near all-time highs simply because they have very little other credible uses for excess cash.
However, like most good things, this can be carried too far. What happens when companies continue to buy back shares beyond the capacity of their excess free cash flow? They increase their debt levels weakening their balance sheets and potentially sacrifice their future growth. We think Exxon Mobil during the pullback in oil prices in 2015 and 2016 illustrates this point very well. Despite massive sector-specific headwinds, Exxon was adamant that it would continue to buy back shares and maintain and even increase its dividend during a time of real turmoil in the energy sector. This could be viewed as admirable. Conversely, this could be tremendously short-sighted in terms of maximizing the long-term value of the company. Under the hood, however, as fundamentals weakened the quality of Exxon’s balance sheet deteriorated. From December 2014 to December 2016, cash balances declined by 21%, debt rose by 38% and net debt increased by 46%. In addition, the company reduced capital expenditures by 51%, putting a significant amount of future growth at risk, or at least substantially deferring it. We took the stances that investors should have been concerned. Ironically, this “beacon of consistency” within the Energy sector garnered significant investor attention, outperforming most of its peers during this time as investors sought “safety” in Exxon’s scale and its “blue chip” reputation.
We learned this week, that on an aggregate basis, companies seem to be heading down this path of further balance sheet weakness — for the first time since the financial crisis, companies have given back more to shareholders than their free cash flow, according to Goldman Sachs. Further, over the past 12 months, companies (ex-Financials) have lowered cash balances by $272 billion while increasing corporate leverage as gross debt outstanding has risen by 8% over the same period.
Yet, as with Exxon mentioned above, companies with higher debt levels have outperformed the broader market as investors eye Fed rate cuts. According to Goldman Sachs, since the start of June, weaker balance sheet companies have seen a return of 12% vs. 8% for their counterparts in anticipation that the cost of borrowing will get even cheaper.
Absent global expansion, all other things being equal, we believe companies that weaken balance sheets are eventually met with lower stock prices. That is why, when we look at financial stability of individual companies in our SCOREing process, we pay particular attention to changes in free cash flow, debt levels, and credit ratings in determining whether earnings growth can be supported and maintained.
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The views presented herein are those of Validus Growth Investors, LLC (“Validus”) as of July 2019 and are provided for informational purposes only. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. The information is based on the economic and market conditions as of this date. The information is not intended as a discussion of the merits of a particular offering and should not assume that any discussion or information provided herein serves as the receipt of, or as a substitute for personalized investment advice from Validus or any other investment professional.
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